On Austro-European business cycle theory

On the origins of the crisis, Raghuram Rajan writes:

It is true that the European Central Bank was less aggressive, but only slightly so; It brought its key refinancing rate down to only 2 percent while the Fed brought the Fed Funds rate down to 1 percent. Clearly, both rates were low by historical standards. More important, what Krugman does not point out is that different Euro area economies had differing inflation rates, so the real monetary policy rate was substantially different across the Euro area despite a common nominal policy rate. Countries that had strongly negative real policy rates – Ireland and Spain are primary exhibits – had a housing boom and bust, while countries like Germany with low inflation, and therefore higher real policy rates, did not. Indeed, a working paper by two ECB economists, Angela Maddaloni and José-Luis Peydró, indicates that the ultra-low rates by both the ECB and the Fed at this time had a strong causal effect in relaxing banks’ commercial, mortgage, and retail lending standards over this period.

That is taken from Rajan's response to the recent Krugman-Wells review of his book.  I am especially interested in this passage because I once made a version of Krugman's argument myself.

If you read the whole review, and response, you will see that this has become what is known as a "contested exchange."  Hat tip goes to Clive Crook.


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